Frameworks for Monetary Stability
Chapter

26 Issues on Placing Banking Supervision in the Central Bank

Editor(s):
Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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Author(s)
JOSÉ TUYA and LORENA ZAMALLOA 

Central banks in many countries are being modernized, i.e., they are implementing the operational changes required to enable a central bank to perform the functions expected of it in a market economy. In some countries, banking supervision is one of those functions, while in others it is entrusted to an independent government agency or in some cases to the Ministry of Finance. As a result of this diversity, the issue of whether to place banking supervision in the central bank is often debated during modernization.

The main goal of monetary policy is to preserve the domestic and external stability of the currency, and the purpose of banking supervision is to ensure the safety and soundness of the banking system. Supporters for placing banking supervision in the central bank claim that monetary policy and banking supervision are closely related, and that their goals cannot be attained independently, i.e., controlling inflation will be difficult during a banking crisis and having a sound and stable financial system will be trying under unstable macro-economic conditions. However, those who oppose placing banking supervision in the central bank argue that the objectives of monetary policy and banking supervision may conflict at times. For example, actions by the bank supervisor may offset central bank attempts to increase lending and liquidity. Regulatory limits on asset growth to meet capital standards, increased provisioning for problem loans, and liquidity ratios limiting loans as a percentage of deposits may limit the banks’ ability to increase lending activity in response to an increase in market liquidity. On the other hand, monetary policy actions that induce changes in interest rates, central bank refinancing facilities, credit ceilings, and reserve requirements affect the liquidity and profitability of banks.

The purpose of this paper is to analyze whether banking supervision should be a function of the central bank in light of the possible conflict of interest with monetary policy. The paper first provides information from a survey conducted by the Monetary and Exchange Affairs Department of the Fund on existing supervisory arrangements in Fund member countries. The goals and institutional requirements of the banking supervision and monetary policy functions are then discussed, followed by an examination of the advantages and disadvantages of entrusting banking supervision to a department of the central bank. Finally, the paper briefly explores alternative institutional arrangements, such as forming an independent agency or elevating the rank of banking supervision in the central bank to semi-independent status, and presents a brief conclusion.

Supervisory Arrangements

A survey of Fund member countries disclosed that bank supervision is conducted by the central bank in over 60 percent (see Table 1) and that the Western Hemisphere was the only region where the percentage declined to 50 percent. Nevertheless, in over 80 percent of Asian, African, and Middle Eastern countries, banking supervision is a function of the central bank.

In the Western Hemisphere, countries whose central banks are without banking supervision authority include Bolivia, Canada, Chile, Colombia, Ecuador, El Salvador, Guatemala, Mexico, Nicaragua, Peru, and Venezuela. In Argentina, Brazil, Costa Rica, Guyana, Paraguay, Uruguay, and Honduras, banking supervision is a function of the central bank. In most Caribbean countries, banking supervision is a statutory function of the Ministry of Finance, which, typically, has delegated the activity to the central bank. In the United States, banking supervision is performed by the central bank and by other government agencies.

In Europe, central banks in the United Kingdom, France, Greece, Italy, Luxembourg (Monetary Institute), the Netherlands, Portugal, and Spain are entrusted with bank supervision.1 In Austria, Belgium, Denmark, Germany, Ireland, and Switzerland, bank supervision is performed by a separate government agency. As a result of the amendments to central bank charters, related to the deliberations on a European monetary and economic union, the issue of the placement of the banking supervision function is being reviewed in both European Community (EC) and non-EC countries (such as Spain and Austria). The Maastricht Treaty does not include banking supervision as a function to be assigned to the future European Central Bank.

Table 1.Supervisory Arrangements in Fund Member Countries1
Region2Central BankDepartment of Ministry

of Finance
Other
Africa4101
Asia2532
Europe I2117
Europe II1500
Middle East1601
Western Hemisphere17314

See Appendix I for list of countries by region.

Countries have been divided following Fund area department allocations. Asia includes Central and Southeast Asia.

See Appendix I for list of countries by region.

Countries have been divided following Fund area department allocations. Asia includes Central and Southeast Asia.

However, the distribution of responsibility for banking supervision is not as clear-cut as it may seem. Although ultimate responsibility may be assigned to an institution, a number of interrelationships may also exist between government institutions. For example, in Germany, the Federal Banking Supervisory Office is solely responsible for sovereign acts such as granting and revoking licenses, but off-site supervision is carried out by the Deutsche Bundesbank. In Japan, the Ministry of Finance has broad responsibility for the regulation and supervision of financial intermediaries, but the Bank of Japan also has authority to conduct examinations of banking activities and on-site inspections (Pecchioli, 1992). In the United States, the Federal Reserve Board has supervisory authority over some 1,200 state-chartered banks that are members of the Federal Reserve System. However, the Office of the Comptroller of the Currency supervises the approximately 4,000 federally chartered banks (all of which are members of the Federal Reserve System), and the Federal Deposit Insurance Corporation supervises the approximately 6,000 state-chartered banks that are not members of the Federal Reserve System. In addition, state authorities also supervise state-chartered banks. In France, the tasks of defining general operating rules, licensing, and sanctioning are assigned to three collegiate bodies: the Banking Regulation Committee, the Credit Institutions Committee, and the Banking Commission, respectively. The Governor of the Bank of France and the Minister of Finance, or their designees, sit on the boards of the three commissions as chairmen or vice chairmen. In addition, bank inspectors are employed by the Bank of France. Similarly, in Guatemala, the bank supervision agency is an appendix of the Monetary Board, which also oversees the central bank. In Mexico, banking supervision is a function of a separate agency, but prudential regulation is the authority of the Ministry of Finance.

In Eastern Europe, Hungary established a separate bank supervisory agency during the conversion process from a centrally planned economy to a market economy. In Bulgaria and the Czech Republic concerns were expressed that an autonomous central bank that is also in charge of bank supervision is too powerful an institution. Although Bulgaria and the Czech Republic have retained bank supervision authority in the central bank, the issue continues to be discussed in both countries. In Poland and Romania, bank supervision is in the central bank. In countries of the former Soviet Union and the Baltic States, bank supervision remains a function of the central banks.

In Asia, Africa, and the Middle East, banking supervision is performed by the central bank. Only Lebanon, South Korea, and Japan reported having the responsibility for banking supervision assigned to the Ministry of Finance. However, as previously mentioned, in Japan the central bank also has banking supervision responsibilities.

In general, financial crises often lead to the review of supervisory responsibilities and practices and to debate over who should perform bank supervision. Many studies have linked inadequate supervision at the time of financial reforms as a contributor to the spread of financial crises (Sundararajan and Baliño, 1991). In the United States the regulatory and supervisory system was inadequate to deal with the new activities that savings and loan associations were involved in as a result of deregulation. “Unsophisticated” and “ill-trained” examiners have been cited as contributing factors to the collapse of the savings and loan industry.2

In the three Nordic countries, the issue of who should perform banking supervision was discussed after the recent financial crises. In Norway, in an effort to strengthen supervision of the financial system, a proposal to merge the banking, securities, and insurance commissions with the central bank was presented to Parliament in 1992. However, Parliament rejected the proposal because of concerns that the supervision function would create a conflict of interest at the central bank due to its monetary policy and lender-of-last-resort responsibilities.

In Finland, the Parliament approved the Financial Supervision Act in May 1993, which changed the status of the Office of Banking Supervision from an autonomous office under the Ministry of Finance to an autonomous body under the central bank. The structure has been designed to retain the independent decision-making capacity of the Office of Banking Supervision. The change in institutional arrangements is expected to result in a more efficient use of resources and to enhance the stature of the bank supervision function.

In Latin America the process of restructuring the financial sector, after the financial crises of the 1980s, has included the reassessment of the bank supervision function for the purpose of enforcing new prudential regulations or reversing the loosening of prudential controls that accompanied the liberalization of financial markets in the late 1970s. For example, in Bolivia, El Salvador, Nicaragua, and Venezuela, the establishment of an independent government agency to perform banking supervision was undertaken as part of financial restructuring programs.

Although this paper focuses on the issues associated with assigning banking supervision to the central bank, a brief mention of another possible arrangement should be made. In a few countries banking supervision is a function of the Ministry of Finance or its dependency (Japan, Mexico, and the United States). This arrangement raises issues concerning possible lack of political autonomy and budgetary independence which, as discussed later in this paper, are important elements of an adequate banking supervision function. In addition, it also raises issues of conflict with fiscal policy because government expenditures or revenue considerations may postpone necessary supervisory actions. For these reasons, entrusting banking supervision to the Ministry of Finance is considered a less favorable option than entrusting the central bank or an independent agency with the banking supervision function.

Banking Supervision and Monetary Policy

To understand the links between banking supervision and monetary policy let us examine the relationship between these two functions, their possible conflicts of interest, and their institutional requirements.

Relationship of Banking Supervision and Monetary Policy

The relationship between these two functions can be analyzed by examining their goals and the effect of their instruments on the banking sector.

Goals of Banking Supervision and Monetary Policy

As stated earlier, the primary goal of banking supervision policy is to ensure the safety and soundness of the banking system, while the primary goal of monetary policy is ensuring the stability of the currency. A number of reasons explain why monetary policy decision makers should also be concerned about the safety and soundness of the banking system. First, an unsound financial institution may pose a threat to the integrity of the payments system, which has a fundamental role in the implementation of monetary policy. Liquidity or solvency problems in a bank may result in a large provision of central bank credit to contain the spread of settlement failure from one participant to another (Baliño and others, 1994),

Second, an unsound banking system affects the transmission of monetary policy signals. Banking systems characterized by a high percentage of nonperforming loans usually have high interest rate spreads that generally translate, at least in the short run, into high lending rates and cause disintermediation, which, in turn, weakens monetary control. Moreover, in case of a monetary easing, the ability of banks to boost lending to intended levels will also be affected because of the continuing burden of nonperforming loans. In addition, the experience in Latin America’s Southern Cone countries shows that high debt/equity ratios of nonfinancial firms led to distress borrowing. Banking systems characterized by such borrowing have an interest-inelastic demand for credit which, in turn, tends to perpetuate high interest rates (Sundararajan and Baliño, 1991).

Third, an unsound banking system affects resource allocation. The extension and refinancing of overdue loans tend to limit credit to new borrowers, and credit loses its revolving character. Fourth, an unsound financial system magnifies a banking crisis and increases the cost of monetary policy. Let us assume that the government apparatus for supervising is fairly weak—i.e., the financial sector is not compelled to observe adequate prudential standards—and that the government provides deposit insurance (or implicit guarantees) to depositors. Under these circumstances, there is a moral hazard problem. A bank may decide to undertake excessive risks based on the presumption that if the firms repay the loan, the bank will have higher profits, but if the firms are unable to repay, the bank will accumulate losses that in the end will be borne by the deposit insurance agency, the monetary authority, or the government budget (McKinnon, 1989).

Bank supervisors should also be interested in having a stable currency. First, if the environment in which banks operate is full of uncertainties, or if there are frequent and contradictory changes in macroeconomic policy, an increased potential for bank failures will prevail. For instance, high and volatile inflation may provide wrong market signals, causing misallocation of resources and thus endangering the credit decisions of bankers. Second, significant misalignments in macroeconomic variables such as real exchange rates or real interest rates may later, when the realignment occurs, increase the financial burden in the real sector and therefore increase the risk of loan default (Sundararajan and Baliño, 1991).

Monetary Effects of Banking Supervision

Bank regulators use a variety of tools to minimize moral hazard problems and encourage banks to act soundly and competitively. Regulators restrict the composition of banks’ assets, liabilities, and capital by setting balance sheet requirements such as capital adequacy, loan classification and provisioning standards, and liquidity requirements. Balance sheet requirements generally seek to limit bank risk. However, they also have some undesirable effects, such as reducing the flow of credit to new ventures that are potentially productive, but risky. This reduces the efficiency of the investment process. Moreover, they may have an impact on monetary aggregates and thus on interest rates. In the short run, banks can adjust interest rates to offset the costs of complying with balance sheet requirements.

Capital Adequacy. In the short run, minimum capital asset ratios may pose a limit on asset growth, thus establishing a constraint on expansionary monetary policy. Expansions of bank activity could only occur if the overall capital requirement is not binding. This is so whether regulators impose a simple capital asset ratio or a risk-weighted capital asset ratio. In the United States, the United Kingdom, and Japan, the strengthening of bank capital positions has coincided with concern about a tightening of bank credit conditions.3

The implementation of the Basle Accord may have some additional implications for monetary policy.4 First, it may distort credit allocation or induce banks to adjust interest rates. The risk/capital asset ratio has created some incentives to rearrange banks’ asset portfolios. Banks may rearrange their balance sheet to stretch equity capital resources over a larger dollar value of activities by moving resources away from high-risk-weighted assets toward lower-risk-weighted assets. For example, since corporate lending carries a 100 percent risk weight, banks will be less inclined to finance this sector than they will to finance mortgage-backed loans on residential property, which have a 50 percent risk weight. Alternatively, banks may increase the interest rate differential between corporate and mortgage lending to cover the increased capital costs.

Second, to circumvent the costs of complying with the capital asset ratio, commercial banks may resort to the securitization of bank assets, which is a form of bank disintermediation that, in turn, weakens monetary control. By securitizing their loans, banks get the loans off their books and reduce their risk-weighted asset levels.5 Note that where monetary policy operates by directly constraining commercial banks’ credit levels, loan securitization prompts concerns about the effectiveness of such direct monetary control because operating targets are set at the level of the banking system accounts. However, securitization is less of a concern under indirect monetary control where operating targets are set at the level of the central bank balance sheet, and monetary policy operates through interest rate effects diffused throughout the financial system. In this case, the securitization of bank assets mostly distorts the value of conventional monetary aggregates that guide monetary policy (Davis, 1990).

Asset Classification and Standards. Asset classification and provisioning standards may have a procyclical effect on credit growth. During a period of economic slowdown, a bank’s volume of nonperforming assets is likely to be increasing and the bank supervisor will be requiring higher provisions for possible loan losses and applying pressure on the banks to improve the quality of their portfolios. The banks’ implementation of the bank supervisor’s recommendations (and prudent banking principles) would result in tighter credit during an economic recession.

Liquidity Requirements. The maintenance of adequate liquidity to meet all obligations as they fall due is fundamental to banking. Banks should be able to manage liquidity in such a way as to generate resources sufficient to cover the potential outflow of funds. The ability to meet obligations may be provided by holding cash and other liquid assets. However, a liquid asset requirement may also limit credit to the private sector by forcing banks to hold more government bonds.

While, until recently, the use of liquid asset requirements reflected a mixture of monetary policy and prudential objectives, in more recent years it has been regarded as a prudential tool, mostly of a nonbinding and indicative nature. The economic literature on the properties of the liquid asset ratio as an instrument of monetary policy shows that it is inferior to the reserve requirement ratio as an instrument of monetary policy (Clark, 1985). The liquid asset ratio includes assets such as government securities or good quality commercial paper, which provide the necessary liquidity to meet the obligations of a bank but are outside the monetary authority’s control.

Other Prudential Regulations. Other prudential regulations such as concentration limits on interbank lending appear desirable. However, too rigid limitations could effectively reduce the scope for the development of a domestic money market and hinder the efficiency of indirect monetary management. This particular concern highlights a broader issue—i.e., how to balance prudential regulations with attaining other objectives, such as the development of money markets.

Banking supervision may assist in promoting competition and efficiency in the financial system, which may help to smooth the transmission of monetary policy signals and produce reasonable bank spreads. The 1980s was a decade in which many countries accelerated their transition from direct to indirect monetary policy procedures. In many industrial countries, monetary authorities are no longer relying on direct controls, such as credit and interest rate ceilings, to implement monetary policy and they ultimately achieve their goals in terms of inflation and balance of payments. Indirect monetary policy procedures use monetary policy instruments such as open market operations and discount rate changes to affect interest rates. These instruments lose their effectiveness when banks are not able to adjust their own interest rates to such measures competitively and efficiently.

In addition, lack of competition may result in large bank spreads. A banking firm behaving in an oligopolistic fashion will try to capture, at least in the short run, a “higher than normal” profit by charging a higher lending rate and paying a lower deposit rate; i.e., the interest rate spread will be higher than in the competitive case. Finally, lack of competition may also lead to collusive practices that may result in distorted interest rates.6

Microeconomic Effects of Monetary Policy

Monetary policy may also have microeconomic effects on the banking system. A tight monetary policy may have an impact on bank solvency. If there is a macroeconomic imbalance that calls for a tight monetary policy, it is likely that this will lead to high interest rates, which in turn will increase the risk of loan default in the banking system. Thus, it may conflict with the objective to preserve the soundness of the banking system. However, the alternative situation, i.e., to relax monetary policy, could be even more dangerous because it might worsen macroeconomic problems in the long run. From the central bank perspective, macroeconomic stabilization has a higher priority than dealing with the financial situation of individual banks.

Monetary policy decisions may also induce changes in bank refinancing facilities, reserve requirements, credit ceilings, exchange rates, the liquidity conditions of the money market, and the liquidity and market value of securities (Schmitz, 1993). All of these decisions affect the liquidity and profitability of banks. Some instruments of monetary policy, such as directed credit policies, may even affect the soundness of banks. A number of mechanisms to direct the allocation of credit may be used: (1) central bank rediscounting of certain commercial bank loans; (2) specific lending by state development banks; (3) regulations mandating banks to lend a certain percentage of their portfolio to specific sectors; and (4) exempting banks that lend to priority sectors or geographic areas from holding a part of reserve requirements.7 The purpose of this policy is to compensate for so-called market failures and distribute credit to sectors that do not have easy access to loans.

However, such directed credit policies have important drawbacks and their effectiveness is questionable. Directed credit may distort the allocation of resources when they are directed to projects with lower rates of return than those that would result from a market allocation. Often, they result in a significant share of nonperforming loans in private and state development banks. For instance, preferential lending under government directives played an important role in the situation of bank distress that developed in Bangladesh in the 1980s (Watanagase, 1990).

Institutional Requirements

Institutional requirements of banking supervision and monetary policy are similar and include: (1) independence from political pressures; (2) coordination requirements of banking supervision and monetary policy; and (3) adequate staffing and resources.

Independence from Political Pressure

Monetary policy requires independence from political pressure to adequately perform its function. The issue of the independence of monetary policy has been discussed extensively in the economic literature and will not be further addressed here.

Banking supervision has the same institutional requirement. It is important that the bank supervisor have independence from political pressure so that decisions can be made with minimal political interference or delays. In supervising the banking system, the supervisory agency may make decisions that will affect the general economy, cause the closing of major banks or businesses, result in losses to depositors, and adversely affect the government budget. These decisions may contradict fiscal goals and the needs of private interest groups.

For instance, recently in the United States the Office of the Comptroller of the Currency was strongly criticized by Congress and the administration for causing a credit crunch through its loan classification and provisioning standards on real estate loans. One of the first actions of the Comptroller appointed by the incoming administration was to loosen prudential standards on loans to small businesses to stimulate growth. This action was taken jointly with the other federal regulators to implement the plans of the new administration.8

Moreover, in dealing with a problem bank, the regulator will classify loans considered problematic—resulting in the bank’s restricting or denying further credit to the borrower. These actions may eventually lead to the borrower’s bankruptcy. Depending on the borrower’s size and influence, pressure may be applied on the regulator by government officials to avoid the bankruptcy of the borrower. The same would apply to a decision by the regulator to close a bank (a decision that may result in losses to depositors and creditors).

As evidenced from the above, the impact of a bank supervisor’s actions may be far-reaching and affect government economic programs and individual politician’s careers. The cost of a bank failure may also affect the fiscal budget through depositor payout and bank restructuring, depending on the country’s financial system and deposit protection schemes.

Coordination Requirements

Given the significant links between monetary policy and banking supervision, close coordination is required between bank supervisors and the central bank—the institution that designs and implements monetary policy. Such coordination is easier when the supervisory function is placed in the central bank. However, when banking supervision is not entrusted to the central bank, the need for close coordination remains and must be institutionally arranged. For instance, the supervisor may have the right to attend the meetings of the board of the central bank and vice versa.

In addition, this arrangement must be supported by a well-defined legal and operational framework delineating the regulatory authority of the central bank and the supervisory agency. For example, the central bank should be responsible for monetary policy instruments, such as reserve requirements, rediscount credit, interest rates, and open market operations, while the supervisory agency should set the coefficients directly related to the operational capacity of the financial entities and their soundness, such as capital adequacy and liquidity requirements. Moreover, to minimize duplication of efforts, a clear information-gathering policy should be established. However, some duplication of effort will be unavoidable, given that it is necessary to satisfy the information needs of both institutions. Finally, a program of temporary staff exchanges between the central bank and the supervisory agency should be developed to help the staff of the two institutions understand better the concerns and needs of each other.

Adequate Staffing and Resources

To properly conduct the banking supervision and monetary policy functions, the institutions entrusted with this function require adequate staffing and resources. Most qualified bank supervisors have or acquire experience that is likely to be attractive to legal offices, auditing firms, businesses, and banks. Similarly, qualified monetary policy decision makers, mainly economists, have or acquire experience attractive to banks. Thus, the salaries offered to bank supervisors and economists should tend to match those prevailing in the above sectors, in particular the banking sector.

Advantages of Central Bank Supervision

The following is a discussion of the advantages of entrusting bank supervision to a department of the central bank.9

Autonomy

Banking supervision will benefit from the autonomy that many central banks, such as the central banks of Argentina and Chile, are now being guaranteed in their charters. As discussed above, autonomy from political pressures is the primary institutional requirement for banking supervision.

Supports Lender-of-Last-Resort Function

Placing banking supervision in the central bank satisfies the information needs of the lender of last resort. As lender of last resort, the central bank must be aware of its borrowers’ financial condition. Central banks are seen as performing this function under two circumstances: in response to a systemic crisis where depositors withdraw their money from the banking system, and in the case of providing emergency liquidity to an individual bank. Assigning bank supervision to the central bank will enable it to have in-house information on the bank’s condition. In addition, it will have knowledgeable staff to advise on whether an individual bank’s borrowing request is justified and on whether the borrower will be able to redress the circumstances that prompted the borrowing need. Having bank supervisory powers will also enable the central bank to better anticipate systemic risk and react to it.

In the United States in 1984, the Report of the Task Group on Regulation of Financial Services concluded the following concerning the Federal Reserve’s role as lender of last resort: “to be effective in carrying out its responsibilities, especially relating to sudden threats to the overall banking system, the Federal Reserve must have certain institutional capabilities. Among these are accurate and timely information concerning financial and economic conditions, as well as the capacity to evaluate the necessity of a government response to particular situations to maintain financial stability’’10. It is the opinion of Federal Reserve Board Chairman Alan Greenspan11 that without the experience and staff capability that the Federal Reserve’s bank supervisory functions provide, the Board would not be able in the future to respond as effectively as it now does to financial crises.

As lender of last resort a central bank must always be aware of the condition of the financial system, and the concern is that, if it must wait for reports from the bank supervisors, the information may not arrive in time to permit an active response by the central bank.

Facilitates Collection of Financial Data

Since design of monetary and bank supervision policy is heavily dependent on information collected from banks, both functions should be in the same institution to ensure the timely availability of such information and avoid an unnecessary reporting burden on banks.

Gauging the Impact of Monetary Policy on Banks

Placing bank supervision in the central bank facilitates the central bank’s ability to gauge the impact of monetary policy decisions on the banking industry. When the central bank restricts liquidity and drives up interest rates, it will need to estimate the impact on banks. To estimate the impact it will need to be aware of the banks’ interest rate sensitivity, the impact on earnings, and the banking system’s ability to withstand a significant decline in earnings. This task will be easier to accomplish if the central bank has the supervisory data base and enough expertise to interpret it.

Having banking supervision authority would also sensitize the central bank to the realities of commercial banking and enable it to better gauge the impact of its policies on banks. The central bank would come into closer contact with banking practice, gather information through its individual contacts with banking institutions, and avoid taking an approach to policymaking that fails to take into account market realities. In turn, this knowledge is helpful in the implementation of open market operations.

Policy Coordination

Placing bank supervision in the central bank facilitates coordination between the two functions. A central bank’s monetary policy decision may affect the banks’ condition and run counter to bank supervision requirements. For instance, the bank supervisor may estimate that the economic evidence points to a recession, and as a result may ask banks to increase their reserves for loan losses and improve credit controls to filter out the weak borrowers that may not survive a recession. These supervisory recommendations may run counter to the central bank’s desire to lower interest rates and increase credit availability to limit the depth of the coming recession. Although both policies would most likely be balanced through negotiations, it is easier if both functions are in the central bank. If an independent bank supervisor attempts negotiations with the central bank before implementation, the ensuing delays may reduce the preventive intentions of its policies. On the other hand, if it acts unilaterally, and must later reach a compromise retracting its policy to satisfy the central bank, then the supervisor may lose credibility with banks.

Policy coordination regarding international issues is also required. The international issues are characterized not only by the fact that supervisory and monetary concerns overlap, but also that they are often in conflict. International monetary and systemic risk concerns may encourage central banks to ask banks to keep on lending to countries experiencing cash-flow difficulties in order to safeguard the international payments system. The same circumstances dictate that the bank supervisor should require that banks increase their loan-loss provisions to cover country risk and reduce exposure to countries experiencing payment delays.12

International Relations of Central Banks

Central banks have intensive international contacts that are very helpful for bank supervision. Central banks are in frequent contact with each other, and some supervisors attend the monthly meetings at the Bank for International Settlements in Basle (mostly Group of Ten countries) to discuss policy coordination. These meetings make possible the timely recognition of adverse developments at banks with international activities, and in emergencies make it possible to hold consultations to find solutions. If the bank supervisor is in a separate agency, he will be left out of the meetings, or may attend only by special invitation when, in the opinion of the central banks, bank supervision issues warrant his attendance.

Funding and Resources

Placing bank supervision in the central bank may insulate it from fiscal budget pressure. As discussed earlier in this paper, banking supervision must be insulated from political pressures, and the provision of funding independent of the fiscal budget helps build such insulation. Central banks are self-funded and generally profitable, and thus would provide insulation from budget pressures on the banking supervision function. If banking supervision is entrusted to the Ministry of Finance, expenditure or revenue considerations may postpone supervisory actions. For example, the supervisor’s attempts to require an increase in reserves for possible loan losses and to write off nonperforming loans may be thwarted by the Ministry, which may be more concerned about the adverse impact on the banks’ earnings and attendant reduction in tax collections. The Ministry of Finance may also apply pressure to postpone the closing of failed institutions to avoid the budget impact of depositor bailouts or significant restructuring costs.

Budget independence may also be achieved if banking supervision is performed by a separate agency. Funding for a bank supervisory agency may come in the form of fees and assessments placed on the institutions it supervises, based on the number of examinations or supervisory hours spent on an institution or based on a percentage of total assets or deposits. This may create opposition to its establishment from banks that are likely to view the expense as another government tax, especially if bank profitability in the country is low. It is easier for the central bank to justify its fees since it provides a package of services without which the banks would have difficulty functioning and it may price banking supervision as part of the package. In addition, establishment of an independent, stand-alone bank supervision agency may not be realistic in many countries in light of available resources and trained personnel.

Disadvantages of Central Bank Supervision

The following is a discussion of the disadvantages of entrusting banking supervision to a department of the central bank.

Central Bank’s Image and Independence

Placing bank supervision in the central bank may tarnish its image. The central bank needs to maintain a certain image to keep the trust of the government and the public. Being involved in the failure of a bank it supervises and having its supervisory actions questioned may hurt the central bank’s credibility. This may further extend into giving the government an excuse for increased intervention into the central bank’s activities. Also, as will be later addressed, the central bank may be tempted to keep banks open at any cost to avoid a loss of confidence in itself and to protect its reputation.

For example, in the United States, the regulatory agency responsible for supervising the thrift industry (the Federal Home Loan Bank Board) was, in essence, put out of business because of the collapse of the industry. Had the Federal Reserve been the primary regulator of the thrift industry, at the very least it may have lost some prestige and perhaps some autonomy.

In addition, bank supervision and regulation is a function more closely related to the exercise of general government authority; that is, the executive branch and its function will require interaction with other agencies, such as the judicial branch. Monetary policy is a macroeconomic activity that touches individual institutions only indirectly, especially in market-based economies, while regulatory and supervisory policy involves direct control of individual banks. If the central bank assumes regulatory authority, it will get involved in the day-to-day exercise of governmental authority which may, in extreme circumstances, involve the central bank in partisan politics, thereby unavoidably endangering its independence.

Conflicts of Interest

Many times the objectives of monetary policy and bank supervision are in conflict, and a central bank able to control both areas may produce biased policy decisions. Operational conflicts also arise as monetary policy and supervision activities are intermingled. Two examples follow.

Lender of Last Resort. One of the central bank’s functions as lender of last resort is to provide temporary liquidity to sound banks that are experiencing a short-term liquidity crunch. If the lending function is not adequately managed, the central bank may find that it has loaned short-term funds to banks experiencing long-term liquidity shortages that are due to high levels of nonperforming assets. This may create a conflict for the central bank in that it may be hesitant to recognize a bank failure if it has large amounts of credit outstanding to that bank. It may be tempted to keep providing funds to the bank, hoping for a recovery; however, if one is not achieved, then losses would be greater than they would have been if the bank had been closed at an earlier stage.

Monetary Instruments. The central bank may employ access to the discount window and monetary reserves as banking supervision sanctioning tools to encourage banks to implement supervisory recommendations. The use of monetary tools for banking supervision purposes results in two adverse consequences: (1) the banks’ ability to appeal supervisory sanctions may be severely restricted by the additional burden of monetary penalties imposed by the central bank (raising reserves, limiting access to the discount window), which make the appeals process unbearable because of the time and costs involved; and (2) the elimination of the advantage of having a neutral lender-of-last-resort facility. This conflict may also appear when the central bank applies bank supervisory sanctions to effect monetary policy—for example, denying approval of a branch license to a sound bank in an attempt to coerce the bank into more active participation in the central bank’s open market operations.

By separating the two functions in different institutions, a system of checks and balances is set in motion that will prevent either institution from exerting undue influence on the economy. The checks and balances provide a system for consultation that may result in better supervision and monetary policy coordination and development by providing both views with equal representation. If both functions are in the central bank, the exchange of information and coordination are easier from an operational point of view but run the risk of monetary considerations being given greater weight. However, with the advent of electronic information systems, operational considerations lose relevance, as the exchange of information is significantly expedited. For example, in the United States, the collection of financial information from banks is centralized and then shared by the three federal supervisors. In Germany, the Deutsche Bundesbank collects the financial information, which it then shares with the supervisory agency. Naturally, substantial coordination is essential to avoid duplicate reporting by banks.

Separation of the functions will also provide the executive and legislative branches of government with additional independent assessments of the impact of monetary policy on the financial system. This would also increase and promote open debate and discussion over monetary and supervision policy issues, and it would ensure that both sides of the issue are considered by the government and the public.

Emphasis on Monetary Policy

The central bank may place higher emphasis on its monetary policy activities at the expense of bank supervision. For example, it may limit new banking powers and investment instruments in order to limit risks to the banking system and maintain the effectiveness of its existing monetary policy tools. This would result in decisions to expand banking powers being based on their impact on the central bank’s ability to manage monetary policy and not on their benefits to the banking industry or their inherent risk.

Bank supervision goals and examination objectives may be distorted by an overemphasis on monitoring compliance with the monetary policy targets. Supervisory resources may be spent monitoring compliance with credit ceilings and reserve requirements, verifying monetary reserve calculations by banks, and collecting and analyzing bank data with monetary policy significance but with little prudential monitoring value. This is common in countries with significant regulatory control over banks.

The emphasis on monetary policy may also reflect itself in staffing and career advancement. Promotional opportunities and pay scales may be tilted in favor of economists, while bank supervisors are limited to their functional area.

Confidentiality

Confidentiality may be an issue when the central bank is involved in supervision. Bank supervision involves a high degree of confidentiality and requires the safeguarding of sensitive information not only on the bank’s financial condition but also on its borrowers. This confidentiality is easier to maintain in a bank supervisory agency whose activities are limited to supervision and may be protected from disclosure than in a central bank with a large array of functions, many of which are usually subject to substantial disclosure and scrutiny. Exchanges of information with the central bank must be carefully monitored to avoid any breaches of confidentiality.

Developments in the Financial System

The changing marketplace and the internationalization of banking diminish the advantages and, therefore, the need to have bank supervision assigned to the central bank. The changing marketplace and the increased number of financial intermediaries (foreign and domestic) make it less feasible in a developed financial market to expect the central bank to supervise all the financial intermediaries that are affected by its decisions. The central bank will need to develop the ability to perform its function by relying on financial information provided by other supervisors.

The internationalization of banking also weakens the argument that a central bank must have supervisory responsibilities. As the number of foreign branches and subsidiaries in a country increases, the more the host country’s central bank must rely on supervisory information provided by the home country’s bank supervisor. As recommended by the Basle Committee on Banking Supervision, foreign branches should be supervised for liquidity purposes by the host country and for solvency purposes by the home country. Moreover, the Deutsche Bundesbank’s Governor has recommended that when the European Central Bank becomes established it should involve itself only in monetary policy issues, and that bank supervision should be assigned to the national authorities (Tietmeyer, 1991).

Alternative Institutional Arrangements

Essentially, there are three types of supervisory arrangements—i.e., entrusting banking supervision to a department of the central bank, to a department of the Ministry of Finance, or to an independent agency. Any arrangement that combines any of these options is considered a hybrid option. The preceding discussion presented the advantages and disadvantages of entrusting banking supervision to a department of the central bank. The Ministry of Finance alternative has been discarded as an option. Two possible alternative arrangements are briefly discussed below: (1) an independent supervisory agency; and (2) a hybrid option, elevating the rank of banking supervision in the central bank to semi-independent status.

Independent Agency

In theory, independent supervisory agencies have a number of advantages. These include the ability to insulate banking supervision from political pressures; a well-defined task; the minimization of conflicts of interest; a specialized, well-trained, and well-paid staff; and a transparent framework for accountability and operations. In many countries where resources are scarce, however, an independent agency may not be practical, because of limited personnel with sufficient skills as well as budgetary constraints. In addition, institutional arrangements between the central bank and the supervisory agency are required to assure proper coordination between banking supervision and monetary policy, as pointed out above. This may not be feasible in countries where coordination between existing institutions is often difficult.

Semi-Independent Status

Elevating the rank of banking supervision in the central bank to semi-independent status is a hybrid option that is typical of recent central bank laws (Finland, Argentina, Costa Rica, and Uruguay). Under certain circumstances it may be possible to gain similar benefits to having an independent supervisory agency by restructuring the supervisory function within the central bank and by ensuring a degree of independence through regulations and organizational changes to assure that supervisory concerns are addressed. Examples would be ensuring that banking supervision is represented at the central bank’s board by making the position of banking supervision director a senior position at the central bank, perhaps requiring him to report directly to the legislature on the condition of the banking system; ensuring adequate salaries and career paths for inspectors; and establishing a “Chinese Wall” between the banking supervision area and the rest of the central bank, similar to the one established in commercial banks between the Trust Department and the bank’s commercial side.

Since banking supervision would remain in the central bank, this institutional arrangement would have the additional advantage that coordination between this function and monetary policy would be easier. In addition, substantial economies could be derived from drawing on the resources of the central bank. However, this arrangement would be more effective in countries where the central bank enjoys a degree of autonomy.

Concluding Remarks

Banking supervision has significant links with monetary policy; their goals are interrelated, and the instruments of monetary policy and the tools of banking supervision affect the liquidity and solvency of banking institutions. A proper institutional arrangement for the banking supervision function should address the need to meet the functional requirements of banking supervision and monetary policy, such as independence from political pressure, their coordination requirements, and adequate staffing and resources.

The decision to place banking supervision in the central bank should be handled on a case-by-case basis. For economies in transition, where institutions and legal systems are in the process of development, human capital is scarce, and coordination between institutions is often difficult, banking supervision should be entrusted to the central bank. In countries where the legislature is not likely to provide the statutory guarantees to ensure that an independent banking supervision entity has the autonomy and authority required to perform its function, it is also preferable to place banking supervision in the central bank. In response to international pressure in these same countries, the central bank may be ensured a high degree of autonomy by its charter, reflecting the international consensus on the need for an autonomous central bank to ensure adequate monetary policy development and implementation. Many countries are revising central bank charters to provide such autonomy.

Placing banking supervision in the central bank requires taking steps to ensure that the supervisory concerns are properly addressed. This may be handled by elevating banking supervision to semi-independent status and ensuring a degree of independence through regulations and organizational changes. However, in countries with highly developed financial systems, internationally active commercial banks, and electronic information systems, the argument that a central bank must supervise all banking institutions is weakened. For instance, the existence of a large number of financial intermediaries (foreign and domestic) makes it less feasible in a developed financial market to expect the central bank to supervise all the financial intermediaries that are affected by its decisions. The central bank will need to develop the ability to perform its function by relying on financial information provided by other supervisors (foreign and domestic). In this case, the establishment of an independent banking supervisory agency may be an alternative. This, in turn, requires endowing the agency with independence from political pressures and with adequate staffing and resources. In addition, to address coordination requirements, it must be supported by a well-defined legal and operational framework that delineates the regulatory authority of the central bank and the supervisory agency and establishes information collection and sharing policies.

Appendix
Countries and Supervisory Arrangements13
Region and CountryCentral

Bank
Ministry of

Finance
Other

Agency
Africa
AlgeriaX
AngolaX
BeninX
BotswanaX
Burkina FasoX
BurundiX
CameroonX
Cape VerdeX
Central African RepublicX
ChadX
ComorosX
CongoX
Côte d’IvoireX
DjiboutiX
Equatorial GuineaX
EthiopiaX
GabonX
The GambiaX
GhanaX
GuineaX
KenyaX
LesothoX
MadagascarX
MalawiX
MauritaniaX
MauritiusX
MoroccoX
MozambiqueX
NamibiaX
NigeriaX
RwandaX
Sao Tome and PrincipeX
SeychellesX
Sierra LeoneX
SwazilandX
TanzaniaX
TogoX
TunisiaX
UgandaX
ZaïreX
ZambiaX
ZimbabweX
Asia
AustraliaX
BangladeshX
BhutanX
CambodiaX
ChinaX
FijiX
Hong KongX
IndiaX
IndonesiaX
JapanX
KiribatiX
KoreaX
Lao P.D.R.X
MalaysiaX
MaldivesX
MongoliaX
Marshall IslandsX
MyanmarX
NepalX
New ZealandX
Papua New GuineaX
PhilippinesX
SingaporeX
Solomon IslandsX
Sri LankaX
ThailandX
TongaX
VanuatuX
Viet NamX
Western SamoaX
Europe I
AlbaniaX
AustriaX
BelgiumX
CyprusX
Czech RepublicX
DenmarkX
FinlandX
FranceX
GermanyX
GreeceX
HungaryX
IcelandX
IrelandX
IsraelX
ItalyX
LuxembourgX
MaltaX
NetherlandsX
NorwayX
PolandX
PortugalX
RomaniaX
Slovak RepublicX
South AfricaX
SpainX
SwedenX
SwitzerlandX
TurkeyX
United KingdomX
Yugoslavia, formerX
Europe II
ArmeniaX
AzerbaijanX
BelarusX
EstoniaX
GeorgiaX
KazakhstanX
Kyrgyz RepublicX
LatviaX
LithuaniaX
MoldovaX
RussiaX
TajikistanX
TurkmenistanX
UkraineX
UzbekistanX
Middle East
Afghanistan, Islamic State ofX
BahrainX
EgyptX
Iran, Islam Rep. ofX
IraqX
JordanX
KuwaitX
LebanonX
LibyaX
OmanX
PakistanX
QatarX
Saudi ArabiaX
SudanX
SyriaX
United Arab EmiratesX
YemenX
Western Hemisphere
Antigua and BarbudaX
ArgentinaX
The BahamasX
BarbadosX
BelizeX
BoliviaX
BrazilX
CanadaX
ChileX
ColombiaX
Costa RicaX
DominicaX
Dominican RepublicX
EcuadorX
El SalvadorX
GrenadaX
GuatemalaX
GuyanaX
HaitiX
HondurasX
JamaicaX
MexicoX
NicaraguaX
PanamaX
ParaguayX
PeruX
St. Kitts and NevisX
St. LuciaX
St. VincentX
SurinameX
Trinidad and TobagoX
United StatesX
UruguayX
VenezuelaX
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Even though the Banking Commission in France is entrusted with banking supervision, bank inspectors are employed by the Bank of France.

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The 1988 Basle Accord was an agreement on a framework for measuring capital and setting minimum capital standards for banks at the international level. A minimum ratio of capital to risk-weighted assets was set at percent. Assets and off-balance-sheet transactions are assigned risk weights that are meant to reflect the relative credit risk of those assets. A higher weighting brings with it a requirement for a larger capital base. Loans to corporate customers, for example, carry a risk weighting of 100. while housing loans have a risk weighting of 0.50. In contrast, loans to official borrowers in the Organization for Economic Cooperation and Development attract a zero risk weight.

Since loan packages generally include low-risk assets, the securitization of bank assets may also increase the risk level of corporate loans retained by the banks.

Prudential supervision may contribute to improving competition and efficiency through its regulations on excessive concentration in assets, its licensing and branching policy, and the asset classification and provisioning function. In addition, a regulatory framework that treats equitably domestic and foreign banks (public and private, as well) will foster a competitive banking system.

For more information on directed credit guidelines in Latin America, see Morris (1990).

In an Interagency Policy Statement on Credit Availability, dated March 10, 1993, a program directed at improving credit availability was announced. The program covers five areas: (1) lending to small and medium-sized businesses: (2) real estate lending and appraisals: (3) appeals of examination decisions and procedures: (4) examination processes and procedures: and (5) paperwork and regulatory burden.

These advantages and disadvantages are discussed in various sources, which include Heller (1991), Muller (1984), Tietmeyer (1991), Morris and others (1990b), Schmitz (1993), and Swinburne and Castello-Branco (1991).

Report of the Task Group on Regulation of Financial Services (Washington: U.S. Federal Reserve Board, July 2, 1984).

From a letter written by Federal Reserve Board Chairman Alan Greenspan to Henry B. Gonzalez, Chairman, Committee on Banking, Finance, and Urban Affairs, United States House of Representatives, dated June 19, 1991.

An example of this occurred in 1987 when the U.S. Federal Reserve opposed Citicorp’s decision to increase reserves against loss on Latin American exposure. The Federal Reserve feared that the decision might disrupt relations between Third World nations and the international financial community. In contrast, the two other federal regulators (the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation) applauded CiticorP´s decision. (See Washington Post issue of June 26, 1988, “As Banking Crisis Grows Regulators Collide.”)

The table presents the results of a 1991 survey on supervisory arrangements. In mixed supervisory systems, countries have been classified under the institution that has regulatory power.

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